The Process Behind Constructing Passive Equity Portfolios
Updated: Sep 24
The trend of using passive funds to construct equity portfolios is gaining traction among Indian investors. I have explained the benefits of using passive funds for portfolio construction in my earlier articles.
But our understanding of the process behind picking passive funds needs more clarity. Therefore today I am going to talk about the nuances involved in the process of picking passive funds.
We must first understand the prerequisites for successful passive investing. Passive products are primarily meant for any investor :
1. Who wishes to lay emphasis on avoiding serious mistakes and losses, and
2. Avoid the effort and frequent decision making involved with fund research and selection.
Apart from these criteria, the investor must have a clear goal and asset allocation strategy in mind.
Index funds and Exchange Traded Funds (ETFs) are the two primary avenues used for passive investing. Let us first understand the process behind picking index funds. When picking index funds, the first criterion is the choice of a benchmark index. Investors must primarily stick to funds that are benchmarked to the Total Returns of a large cap index. It is important to pick funds from fund houses that are at least 10-15 years old. Schemes must be chosen under the Direct Plan, Growth Option. Any scheme chosen must have been in existence for at least 10 years.
Any index fund investors pick must be adequately liquid. This would ensure ease of transactions and minimise impact costs. Investors must therefore choose from funds that have an AUM (Assets Under Management) of at least Rs 1,000 crore.
Costs are the next important factor that investors have to consider. An annual expense ratio of 0.2% would be a fair fee to pay for a large cap index fund. We further have to ensure that costs remain around the benchmark of 0.2% per annum for the foreseeable future.
Therefore investors should stick to picking funds that track the Nifty 50. Every fund house in India offers a Nifty 50 index fund. The intense competition between fund houses would ensure that costs remain around the current levels over time. A fund costing 0.15% per annum would be no different from one costing 0.2% per annum. Investors must therefore not nitpick between funds on the basis of costs.
Investors may want to use a metric to evaluate the performance of index funds. A metric called tracking difference would be ideal for this purpose. Tracking difference = Fund return – Benchmark total return. The resultant value of tracking difference calculations is usually a small negative number. This is because the return of the fund is typically lower than the total benchmark return. This difference arises since the expenses of the fund are constantly deducted from its NAV. The tracking difference of an index fund can be calculated for any given time period. It accounts for the fund’s expenses and deviations in following the benchmark. It therefore makes evaluation of fund returns more intuitive.
There is also the option of adopting the passive approach using ETFs. But investors must understand that ETFs have limited utility. ETF units are traded in the secondary market. Hence there may be mismatches in demand and supply. In such cases, the price of an ETF can deviate significantly from its NAV. ETFs may also have liquidity issues. So there may be situations where the desired quantity of ETF units cannot be sold at a given point of time. So most investors are better off avoiding ETFs completely.
But ETFs may be relevant for investors who have a low cost broking account. Such investors may consider a Nifty 50 ETF. They may pick an ETF with robust daily trading volumes and no history of paying dividends. A cost 5 to 6 basis points would be a fair price to pay for a Nifty 50 ETF. ETF investors must remember that transactions are executed at the ETF’s price. They must hence remember to compute tracking difference using the price of the ETF and not the NAV.
Investors must remember that all passive products simply mirror the returns of their respective benchmarks. It therefore makes no sense to try and pick ‘the best passive fund’. It is also futile to try finding the fund with the highest AUM, lowest expense ratio or lowest tracking difference. All investors need to do is to shortlist a set of passive products that satisfy the filters given above. They can simply pick a couple of funds from the shortlist in line with their goals and intended asset allocation. Regular rebalancing and reduction of equity allocation may be carried out as required. This would make the exercise of constructing and maintaining equity portfolios much simpler.